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Central Banks IW News 30. April 2015

Watch out: Global Low Interest Rate Trap!

The US central bank Federal Reserve has disenchanted financial markets. Market participants had expected that the “Fed” will hike its policy instrument, the federal funds rate target. The Fed, however, abstained from such a policy move, since Fed-chairwomen Janet Yellen intends to further stimulate the economy with low interest rates – as the Fed said. The strong US-Dollar, on the contrary, could be another reason for the delayed hike. As of now, the threat of a global low interest rate trap is present.

In their press release, Yellen and the Fed governors applied vague formulations: they do not expect a permanent decline in economic activity, but would constrain an increase in the federal funds rate target on further progress in a wide range of economic indicators. Although inflation and employment improved, both indicators still lie below their objectives of maximum employment and two percent inflation. Therefore, the Fed sticks to keeping the federal funds rate within its target corridor of 0 to 0.25 percent, in which it stayed since end of 2008.

Financial market participants already engaged in anticipating an interest rate hike in September. Had Yellen confirmed these expectations, yields on sovereign bonds and mortgages would have been gotten up, since market participants normally incorporate such news into asset prices immediately.

This could be one reason for Yellen’s patience in sticking to low central bank interest rates. But another explanation seems to be plausible too: the strong Dollar, which is not mentioned by the Fed. A hike in the federal funds rate would have put further upward pressure on the Dollar, which would result in more expansive goods and services of US-exporters.

The Dollar is more expansive compared to the last years – also due to the low interest rate policies of other major central banks. An increase in the European Central Bank’s (ECB) policy rate, for example, lies far away. Moreover, the ECB most recently started with its large-scale asset purchase program, which consists of monthly purchases of public bonds in the amount of 60 billion Euros.

Because of this, central banks might be caught in a global low interest rate trap: At the moment it is unpleasant for each central bank to have a stronger currency and thereby more expansive domestic goods and services compared to foreign countries. Hence, there is less incentive for each of them to increase interest rates. But when the low interest rate trap snatches, savers will be losers, since their savings will deteriorate. If such a low interest rate environment persists for years, the social peace will be threatened.

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